Guest Blog: from Gary Connolly of iCubed

Have you ever placed an alarm clock on the far side of the room to prevent yourself from hitting the snooze button in the morning? Or moved a bowl of nuts out of arms reach at a dinner party to stop you from nibbling your appetite away? Or paid more for wine by buying it by the bottle in an attempt to drink less?

I’m guilty on at least two counts (it’s rare for me to buy less than a dozen bottles of wine at a time!) As an economics student I was taught that it does not make sense to place nuts out of arms reach; if I did not want to eat them I would simply choose to stop eating, so why go to the trouble of removing the bowl? According to author and prominent behavioural economist Richard Thaler, the distinction between what we want and what we choose has no meaning in traditional economic theory.

Equally, a decision to press the snooze button on the alarm clock reveals a preference for a few more minutes shut eye. Choosing to wake up is another preference for which leaving the alarm clock on the far side of the room is unnecessary. Self-control problems have no place in the rationalist theory of economics.

To borrow a phrase from Yogi Berra, “In theory there is no difference between theory and practice; in practice there is.” In real life, the decisions we make are not rooted in rational economic theory and this has wide implications for many facets of our lives, none more so than in matters relating to finance.

Take for example the glib assumption of rational decision making that my own industry (investment) has borrowed from the theorists; as a result we have been effectively washing our hands of arguably the most important aspect of what it means to invest successfully; getting investors to stay the course through the inevitable ups and downs along the journey.

In the main, investors do not like volatility and are averse in the extreme to multiple periods of negative returns (which occur with far more frequency than finance theory predicts).

Investors require some emotional comfort along the way. Emotion, however, is to be controlled not pandered to according to the theorists. By betting against the obvious and powerful force of human fallibility the traditional approach to investing is setting investors up for expensive failure.

A more sensible approach is a behaviouralist one, which embraces our own emotional fallibility, and plans for it. So here is my tuppence worth on what a sensible approach to investing should encompass.

To have any practical hope of achieving long term financial objectives, investors need to follow a simple (thought possibly not easy) set of rules.

Rule 1. Use a financial adviser or someone not emotionally connected to the investment.

Despite best intentions, people can get derailed from their investment plans, hitching their wagons to a star in search of the illusive next best thing. Investment returns will not be determined by investment performance so much as it will be by your investment behaviour, and this can be influenced positively by impartial advice. In the spirit of full disclosure, whilst I do not provide financial advice directly to clients, I do work with financial advisers.

Rule 2. Sign up to a plan that is drafted in a period of calm.

A fear of regret that the investment will perform badly, or excessive focus on the possibility of future losses, might make the investor reluctant to undertake good investment advice in the first place. The emotional insurance in this instance usually involves taking less risk than is appropriate given long-term risk tolerance and risk capacity. But doing so also reduces long-term returns, sometimes dramatically. A balanced risk investor that remains in cash may be paying a 4-5% opportunity cost premium for reduced anxiety. This is unnecessary. Draft a plan during a tranquil period and commit to it. A good adviser will act as your emotional coach and provide what you need, which may sometimes conflict with what you want.

Rule 3. Don’t over-monitor your portfolio and make fewer changes than you are tempted to.

It’s a well-documented phenomenon that the more frequently an investor observes the performance of his/her portfolio the more inclined to make changes they are. Activity is your enemy. The cheapest form of anxiety reduction is to simply stop looking at your portfolio as frequently. There may be practical limits to how far this can be pushed, but your trusted adviser is there to monitor things for you (see rule number 1). Though you may receive quarterly valuations you certainly don’t need them.

We only have a certain well of emotional comfort to draw from and it gets depleted; so save it for important stuff. Don’t waste it on the equivalent of guessing a coin flip. Though many in the investment business are loathe to admit it, much of what happens in markets, certainly over the short run, is random and beyond rational explanation. Tune out the noise as much as possible.

The battle against innate biases and self-control issues is a struggle without a finish line so these rules should be kept under constant review. Some people need a little more emotional comfort than others, but no one needs to pay a large percentage premium of their wealth per year to get a little rest. So start with rule number 1 and work from there.

Gary Connolly is Managing Director of iCubed, an investment training, research and consulting company providing investment support to financial advisers and chairman of the valueinstitiute.org. He can be contacted atgary@icubed.ie